4/16/2018 (c) William P. Streng 1

Transcription

1 Chapter 10 p.583 Interest, Taxes & Losses Interest expense is deductible, subject to various limitations. 163(a). What is interest? Rent for the use of money. Why provide a deduction for interest expense? a) Business expense (cf., 162). b) Investment expense (cf., 212). c) Personal interest expense (cf., 262). This treatment is subject to various exceptions, e.g., capitalization requirements. 4/16/2018 (c) William P. Streng 1

2 Limitations on Interest Expense Deductions Limitation examples: 1) Limit on investment interest - 163(d). 2) Obligations not in registered form - 163(f). 3) Personal interest is not deductible, except for home mortgage and home equity debt. 163(h). 4) Disqualified interest & foreign lender. 163(j). 5) Corporate debt-equity classification issues. 385 note: October 2016 finalized regulations. 6) 265(a)(2) re interest to carry tax-exempts. 4/16/2018 (c) William P. Streng 2

3 Defining Interest p.584 Knetch case Permit deductions for this interest expense? Knetch bought deferred annuity bonds for $4 million, paying with $4,000 check and $4 million promissory note. Debt was secured by bonds. Prepaid 1 st year s interest of $140,000 and borrowed back $99,000 and then prepaid $3,465 interest on this 99k borrowing. This procedure was repeated in the subsequent year. In fourth year this arrangement terminated and net equity of $1,000 received from the contract. continued 4/16/2018 (c) William P. Streng 3

4 Knetsch case, cont. Trial court declares this transaction a sham. Sup. Ct. analysis: taxpayer paid a fee of $91,570 to produce this loan arrangement attempting to facilitate a $294,540 interest expense deduction - which enabled a tax reduction of $233,298 (assuming an 80 percent FIT rate). Post-transaction tax provision ( 264) limits this arrangement. But, no enactment date protection here since here a non-existent deal. Held: a sham transaction & no interest expense deduction permitted. Note: Douglas dissent. Cont. 4/16/2018 (c) William P. Streng 4

5 Knetsch case, cont. Is the Knetsch situation ultimately a losing proposition? Depends upon (e.g.,): 1) Whether tax rate is less in the close-out year (i.e., statutory tax rate changes or reduced income for this taxpayer); 2) Capital gains treatment (& significant tax rate differential, e.g., 70% vs. 25%) at time close-out of deal; and, 3) Investment benefits from deferral proceeds. 4/16/2018 (c) William P. Streng 5

6 Goldstein & Economic Substance Rule p.589 Taxpayer won $140,000 in Sweepstakes and (1) borrowed funds and (2) prepaid interest expense (to partially offset some of winnings). Loan proceeds were used to buy U.S. Treasury obligations to provide interest income in a later year. Current economic loss was incurred but expected tax savings: reduced current income tax and pushing certain earnings forward. Holding: No 163 interest expense deduction since no non-tax purpose for the borrowing. 4/16/2018 (c) William P. Streng 6

7 Sham vs. No Economic Substance Should the transaction be treated as even occurring for non-tax purposes (i.e., it is not a sham ), but still not be recognized for federal income tax purposes (i.e., Goldstein case)? See Code 7701(o)(1): economic substance occurs only if: (1) required meaningful change in the taxpayer s economic position occurs, and (2) taxpayer has a substantial purpose apart from federal income tax effects for entering into the transaction. 4/16/2018 (c) William P. Streng 7

8 Question 1, p. 594 What is the tax advisor s responsibility in advising clients in this context? Are professional risks existent? See Problem 1(d) re fake documents. 4/16/2018 (c) William P. Streng 8

9 Question 3, p. 594 Borrow & Life Insurance Remember: 101 excludes the life insurance policy internal build-up from GI inclusion. Borrow to pay for the policy premiums? See 264(a)(3) & (d) disallowing an interest expense deduction for borrowings to fund life insurance (which produces tax-free income). But, see 264(d) concerning (1) paying four of the first seven premium payments and (2) then no limit applies to interest expense deduction. 4/16/2018 (c) William P. Streng 9

10 Question 4b, p. 595 Interest paid by Tenant B rents house and pays rent to landlord. The landlord uses a significant portion of the funds to pay mortgage debt (both P&I). Can tenant deduct any of this interest expense? What if tenant agrees to liability for the mortgage? No - not the tenant s debt. See Code 216 re deduction to tenants when amounts paid to a coop association (what is a co-op for this purpose; cf., condo association). 4/16/2018 (c) William P. Streng 10

11 Question 4c, p. 595 Interest paid by Child Daughter pays mortgage amount for parents (& mortgage amount includes both P&I): a) No interest expense deduction to the child; but, a deduction to the parents for constructive payment by them of the interest expense? b) Daughter becomes jointly liable on the mortgage debt then interest expense deduction to daughter if the debt is genuine. 4/16/2018 (c) William P. Streng 11

12 Question 4d, p. 595 Interest paid to Child Parent executes a promissory note to child (e.g., for $10,000; for gift?) and then pays interest expense (e.g., 7% or $7,000 per year) to child. Questions re availability of deduction: 1) Is the debt genuine, i.e., does it really exist? 2) Is the payment really for interest expense? 3) If really interest expense, is it tax deductible by the parent? What is the real purpose for incurring this debt? 4/16/2018 (c) William P. Streng 12

13 265(a)(2) p. 595 No deduction is allowed for interest expense on debt incurred or continued to purchase or carry obligations the interest on which is wholly exempt from the taxes imposed by this subtitle. I.e., 103 tax-exempt bonds. What is the objective of this limitation? To preclude whipsawing the tax system. Remembering the Haverly case! But, when does this debt exist which causes the actual denial of the interest expense deduction? 4/16/2018 (c) William P. Streng 13

14 Rev. Proc p. 595 Purpose to carry tax-exempts exists where borrowing is incurred to buy the tax-exempts. Also, where the tax exempts are used as collateral for borrowing. But, not where holding tax-exempts and temporarily borrowing in business when a cash deficit exists (i.e., a business needs exception). Cf., Wis. Cheeseman case. continued 4/16/2018 (c) William P. Streng 14

15 Rev. Proc Individuals p. 595 The 265(a)(2) limitation is not applicable to an individual who (1) owns tax-exempts and (2) incurs home mortgage debt (the interest on the home mortgage debt is deductible). Cf., an individual holding portfolio investments (e.g., stocks) & buying tax-exempts on margin (i.e., with stocks as partial collateral for the margin debt)? Is interest otherwise deductible? Yes, except for 163(d) see Yeager case. 4/16/2018 (c) William P. Streng 15

16 Estate of Yaeger v. Commr. P.600 Investment interest - 163(d) limits interest expense deduction to investment income (& not deductible against other business & personal income). But, a 163(d) carryover is possible. Here: significant trading activities, but holding stocks for investment, and not a trader (i.e., not engaged in the business of trading stocks). The management of one s financial investments is not engaging in a trade or business. Here most securities were held for more than 1 year. 4/16/2018 (c) William P. Streng 16

17 Business Interest Limitation TCJA 163(j), as amended in TCJA, disallows a deduction for the net business interest expense of a taxpayer which is in excess of 30% of the adjusted taxable income of the business. This limit does not apply to small businesses, i.e., having gross receipts less that $25 million. Limitation does not apply to a trade or business of performing services. Business interest is any interest paid or accrued on debt allocable to a trade or business. 4/16/2018 (c) William P. Streng 17

18 Personal Interest p (h)(1) specifies: no income tax deduction is available for personal interest (e.g., credit card interest). Consider: No gross income is imputed for income tax purposes from the use of personal property. Therefore (to enable parallel treatment), no interest expense deduction should be available when purchasing personal property on credit. 4/16/2018 (c) William P. Streng 18

19 Personal/Home Mortgage Interest p (h)(2)(D) exception for qualified residence interest to enable interest expense deduction. 163(h)(3) defines qualified residence interest : (1) acquisition indebtedness (limit $1 million debt; but, $750,000 maximum during TCJA-2017), and, (2) home equity indebtedness ($100,000) this deduction is suspended during TCJA. Pre debt is grandfathered. 4/16/2018 (c) William P. Streng 19

20 Personal/Home Mortgage Interest, continued p.606 What about a reverse mortgage? Home mortgage interest? What is a qualified residence - 163(h)(4)(A). Interest on acquisition debt for second homes remains as permitted deduction after TCJA. What was the legislative purpose of 163(h)(4)(C)? 4/16/2018 (c) William P. Streng 20

21 Deduction for Taxes Paid p permits a deduction of certain state and local taxes: e.g., (1) income taxes; (2) real and personal property taxes; but, (3) not sales taxes (except when?) TCJA-2017 limit on annual deduction to $10,000 in aggregate not indexed for inflation. Who is most impacted by this limitation? TCJA no deduction for foreign real property tax unless related to business. continued 4/16/2018 (c) William P. Streng 21

22 Deduction for Taxes Paid p. 610, continued Other taxes paid may be deducted if the cost of the taxes is incurred for business or investment purposes. Alternatively, cost might be required to be capitalized as part of the purchase price. See below (slide 24): Code 164(b)(5) election re state and local sales taxes as deductible (in lieu of state and local income tax). 4/16/2018 (c) William P. Streng 22

23 Rev. Rul p.611 Conflict of laws? Under N.Y. Real Property Tax Law renters are treated as having an interest in real property and are personally liable for the real property taxes on the property. Also: the N.Y. law states that these persons are entitled to a federal itemized deduction for these taxes paid. IRS holds: This is not a real property tax imposed on the renter for FIT purposes. No new economic burden has been imposed on renters from this N.Y. state legislation. 4/16/2018 (c) William P. Streng 23

24 Discrimination when no State Income Tax? p. 613 Discrimination against a state (e.g., Texas) that does not (and will not) impose an income tax? Is this a benefit for taxpayers deducting state income taxes? See, however, 164(b)(5) re an election to deduct state and local sales taxes in lieu of deducting state and local income taxes. How determine the amount? Estimates? Permanent extension at end of 2015 (PATH Act of 2015). Sponsor: Rep. K. Brady (Houston). 4/16/2018 (c) William P. Streng 24

25 Foreign Tax Credit P. 615 An income tax credit (not a deduction) is available for the income taxes paid to foreign governments (including subnational governments). What is the value of a credit in this context? Why provide a credit (rather than a deduction) in this context? Does this produce a detrimental impact against states (i.e., subnational governments ) imposing taxes in the United States? 4/16/2018 (c) William P. Streng 25

26 U.S. Estate Tax - Treatment re State Tax Example of credit vs. deduction: P. 615 U.S. estate tax computation - previously in the U.S. a credit was provided against federal estate tax for death taxes paid to states. E.g., state inheritance taxes and state estate taxes ( piggybacking taxes ). Credit was repealed & the offset became a deduction for state death taxes paid Appropriate to use a deduction and not a tax credit? 4/16/2018 (c) William P. Streng 26

27 Homeowners Benefits & Tax Policy p.615 Are market distortions produced by (1) the home mortgage interest deduction and (2) the real estate tax deduction for the residence? Producing discrimination against renters? Cf., purchase of a condo vs. a co-op apartment. Should the imputed home rental value for an owner-occupant be included in gross income? Does availability of the tax deduction for tax and interest expense enable a whip-saw? Plus: no inclusion of residence gain on sale. 4/16/2018 (c) William P. Streng 27

28 Homeowners & Future Tax Policy p. 618 See effective tax rate on owner occupied housing chart p And, an upside-down effect? See distribution of tax benefits from the home mortgage interest deduction chart p Policy options: 1) Replace interest expense deduction with a credit equal to a percentage of the interest paid. 2) Limit the exemption of gain on residence sale. 3) Repeal state & local property tax deduction. 4) Enable a deduction for rent paid? 4/16/2018 (c) William P. Streng 28

29 Casualty Losses & Personal Deduction p (c)(3) enables (pre-2018) a deduction for losses from fire, storm, shipwreck, or other casualty, or from theft. Is this a form of partial casualty insurance reducing net loss amount? Limitation on deduction to losses - only above 10% of AGI. 165(h)(2). Why? A loss limit per incident must exceed $100. Does claiming the deduction require an insurance claim? See Code 165(h)(4)(E). TCJA limit to losses only in federal disasters. 4/16/2018 (c) William P. Streng 29

30 William H. Carpenter p. 626 Inadvertent disposition by husband of wife s diamond ring into the disposal was a casualty for 165(c)(3) purposes. Ejusdem generis. Ring was a total loss and claimed a $980 casualty loss deduction. Fact determination by the judge based on the husband s credibility. The event was held to be an other casualty for 165(c)(3) purposes. And, no offset for cost of replacement. 4/16/2018 (c) William P. Streng 30

31 Definition of a Casualty p. 628 What is a casualty (for 165 purposes)? Fire, storm or shipwreck. Hurricane Harvey. Sudden or unexpected occurrence. Termites fast-eating vs. slow-eating termites. Theft & mysterious disappearance when was the theft discovered? TCJA limit ( ) to losses in federally declared disasters. 165(h)(5) until year /16/2018 (c) William P. Streng 31

32 What Amount of Casualty Loss Deduction? Reg (b) amount of the deduction is limited to lesser of (1) asset s fair market value (when a depreciated asset), or (2) tax basis. Problem 3(a) p. 628 What was car s fair market value before the accident? Presumably not above $26,000. Loss amount: This current fmv (e.g., $20,000) less $10,000 for current casualty loss deduction amount - $10,000 (before the 10% floor). 4/16/2018 (c) William P. Streng 32

33 What Amount of Casualty Loss Deduction? Cont. Reg (b) the amount of the deduction is limited to the lesser of (1) the asset s fair market value (when a depreciated asset), or (2) tax basis. Problem 3(b) p. 628 Loss of $40,000 - $260,000 less $40,000 for land equals $220,000. See Reg (b)(2)(ii) re unit rule. Insurance: then, less $180,000 insurance proceeds equals $40,000 loss. 4/16/2018 (c) William P. Streng 33

34 What Amount of Casualty Loss Deduction? Cont. Reg (b) the amount of the deduction is limited to the lesser of (1) the asset s fair market value (when a depreciated asset), or (2) tax basis. Prob. 3(c) p. 628; Reg (b)(1) & 8(c). Loss by theft of property with $40,000 basis & $30,000 fair market value: 1) Personal item: deduction of $30,000 (- $100). 2) Business item: deduction of $40,000. 4/16/2018 (c) William P. Streng 34

35 Did a Casualty Loss Really Occur? Consider the result when appreciated property is lost in a casualty the deduction is limited to the income tax basis. 165(b). E.g., consider the theft of a highly appreciated item of jewelry. What happens when the theft insurance proceeds are received in an amount in excess of the income tax basis for the item? 4/16/2018 (c) William P. Streng 35

36 Chapter 10 4/16/2018 (c) William P. Streng 36